What You Need to Know about Cash vs. Accrual Accounting
As every startup grows, many aspects of their business changes. Acquiring the right space, the right talent, and the right partners are often top of mind. Still, one of the concerns every founder should think about early is how their accounting methodology impacts their business’ performance, and understanding cash vs. accrual accounting is key to this.
Nearly every company begins their journey using cash accounting methods. As they transform, the change to accrual accounting will be necessary to support investment and financings, better understand the impact of marketing spend, and effectively grow the business.
How Cash Accounting Works
Much like the name suggests, cash accounting is based on real-time balances in your bank accounts, and transactions as they happen. Revenue is counted when cash is transferred into the company, regardless of when services or products are delivered, while expenses are counted when they are paid.
Even though it is the most basic form of accounting, there are a lot of advantages to cash accounting, especially for early-stage startups. The simplicity allows for founders to better understand how they are handling business finances similar to how they would determine their own budget.
In addition, companies can save money early on quarterly taxes, because they only pay on what they actually made during a quarter. That is: if the company bills a client on net 90 terms, they will pay quarterly taxes on that amount during the quarter when it’s received.
On the downside, cash accounting doesn’t give you a buffer in either accounts receivable or accounts payable. Cash accounting functions on immediate revenue collection and payment, which means you won’t get the same visibility into things like receivables and payables. This can create “Off-Balance-Sheet (OBS),” liabilities and assets, which can dramatically change how you or your investors view the business. For example, under cash accounting companies do not book receivables or payables to the balance sheet which means that there is no financial statement tracking for who owes us money and who we owe money to! To complicate things, cash accounting does not comply with Generally Accepted Accounting Principles (GAAP) either. This doesn’t matter a whole lot for a lot of early-stage companies — once a company grows to over $25 million in sales, they will generally be forced to move to accrual accounting.
How Accrual Accounting Works
Unlike cash accounting, which is dependent on immediate deposits and withdrawals, accrual accounting handles finances as items are billed. For example: if a startup closes a deal for $10,000 with the first payment of $2,500 due immediately, that installment would be booked when it’s billed, not when the payment is received. On the converse, if the company agrees to a purchase from a vendor on a net 30 agreement, the expense would go into the ledger when the purchase is agreed upon instead of 30 days later, when they pay their bill. These kinds of mechanics will require a company to review all three financial statements, instead of just their income statement, to understand the business.
The biggest advantage of accrual accounting is that it complies with GAAP accounting terms set by the Financial Accounting Standards Board, which is steeped in precedents, case law and much more. These sets of standards help companies accurately report their financial picture to their stakeholders in an accurate and clear fashion, as well as federal and state authorities. The goal of GAAP procedures is simple: provide objectivity, create materiality, drive consistency and prudence in reporting a company’s financial picture.
Accrual accounting also gives founders and leadership teams a clearer view of the financial health of their companies, including deeper cash flow analysis, a more accurate burn rate and a more useful balance sheet to understand your company’s financial position. With this information, leaders can determine how to move forward with their plans and products, adjust business goals, or cut wasteful spending when needed.
Because accrual accounting requires more attention to detail, it will likely require additional resources within a company’s financial team. That being said, you probably don’t need to be on an accrual basis as early as you think. In our experience many companies wait until Series A or Series B to make the switch. We believe this makes a lot of sense, as your accrual accountant will be responsible for a much larger accounting footprint than you could have gotten away with at the seed stage — likely meaning more heads. For example, you’ll probably want a CFO, VP of Finance, or controller to sit over this role to ensure the reporting is useful for management.
Another downside of accrual accounting is how it complicates your day-to-day operations. This accounting method relies on long-term financial management, so understanding how much cash on hand can be spent in an emergency or to resolve a situation is difficult. Once again, this type of understanding relies on the people in the finance team, and their ability to pivot when a change takes place.
Cash Accounting or Accrual Accounting; Which One Is Best?
Both cash accounting and accrual accounting have a purpose. Which one works best for your startup may depend on where you are at in your growth.
For new startups with less than $25 million in sales, cash accounting may work best for your needs. With simplicity and agility in mind, cash accounting allows new businesses flex as demands change, and ultimately make quick adjustments to create future growth. Eventually, accrual accounting will become necessary: compliance to GAAP standards and financial forecasting are valuable tools that help investors determine valuation and decide whether or not to place cash and resources in your trust.
Not sure which one works best? The experts at airCFO can help your company determine what works best, and how to manage financial reporting. Reach out to us today, and start a conversation about setting your business up for long-term success.